AFYA: Mr Market Is Mistaken (NASDAQ:AFYA)

Note: This is a Brazilian company. Other than the stock price and valuation where the currency used is in USD, Brazilian Real (BRL) was used.

Introduction

I covered AFYA (NASDAQ:AFYA) 10 months ago in this article, Afya: An Undiscovered Gem With High Return Potential. The stock gained 45% in six months but since January 2024, it has crashed 25.89% compared to SPY which gained 4.64% year-to-date (as of 19 April 2024).

More specifically, the stock price gained almost 7% after the Q4 2023 earnings conference call on 14 March 2024. However, it started plunging after 18 March and has fallen 26%. Was AFYA’s decline part of the wider selloff that began in March 2024 (i.e., not company-specific issues) and therefore we need not be overly worried?

That may not seem to be the case. The table below compares the price changes of AFYA against some of the major ETFs on the market.

The decline in prices of some major ETFs is much smaller in degree and extent compared to the crash in AFYA’s stock price, indicating that the concerns investors have are company-specific, and the price decline was not simply part of the wider selloff.

Yet, the confusing part (to me) was that AFYA’s stock price rose following the earnings call on 14 March 2024, gaining 7% between 14 March and 18 March. Earnings and guidance must have been great or good enough to give investors confidence to buy more.

Analysts AFYA’s consensus price target is $23.52 with a maximum estimate of $26.11 and a minimum estimate of $21.70, with a “strong-buy” rating.

So what caused the 26% decline in one month? These will be examined in the next section. As an AFYA shareholder, I must decide whether to invest more, hold my shares, or sell.

With the full year 2023 results available to us to analyze, let’s begin.

Business Fundamentals

2023 earnings and revenue

The earnings highlights can be found here. According to the Form 6K,

FY23 Adjusted Net Revenue increased 23.9% YoY to R$2,874.1 million. Adjusted Net Revenue excluding acquisitions grew 13.3% to R$2.626.9 million.

FY23 Adjusted EBITDA increased 21.2% YoY reaching R$1,165.7 million, with an Adjusted EBITDA Margin of 40.6%. Adjusted EBITDA excluding acquisitions grew 9.5% to R$1,052.8 million with an Adjusted EBITDA Margin of 40.1%.

FY23 Adjusted Net Income increased 10.5% YoY, reaching R$591.1 million, with an adjusted EPS growth of 11.5% in the same period.

Cash conversion of 97.1% generating R$1,088.8 million of cash flow from operating activities that resulted in a cash position of R$553.0 million.

Around 268 thousand monthly active physicians and medical students using Afya’s Digital Service, an increase of 2.8% over the same period last year.

In a sentence, AFYA did well in 2023.

There is nothing wrong there.

Guidance

I like a company that gives good (i.e., dependable) guidance, since that tells me two things. One, management knows their business. Two, the business is predictable.

AFYA’s management has provided accurate revenue guidance since its IPO in 2019; its actual revenue often exceeded analysts’ estimates.

The company exceeded the high end of its own 2023 net revenue guidance and met its adjusted EBITDA estimates.

This is not an isolated case. Management also met its previously guided adjusted net revenue and adjusted EBITDA.

Equally impressive is how often management has exceeded analysts’ earnings estimates.

All these give me a high degree of confidence that management can deliver their guidance for 2024.

AFYA’s management is confident that it can continue to boost net revenue and adjusted EBITDA in 2024.

There is nothing wrong there.

Until we take a closer look at the projected growth.

Risks of Declining Growth

Although AFYA’s had been growing rapidly over the past few years, the company’s growth rates have been declining.

The increase in revenue, net operating cash flow, and net income from 2018 to 2023 was an impressive 44.53%, 57.22%, and 26.78%, respectively.

However, when compared to the period from 2018 to 2022 when the increase in revenue, net operating cash flow, and net income were 53.85% (versus 44.53%), 67.36% (versus 57.22%), and 34.96% (versus 26.78%) respectively, it is clear that the growth rates have declined substantially.

That could be the reason for smart money abandoning AFYA in droves, which is the fading growth story. According to Morningstar, 13 of the top 20 institutional investors have sold 50% to 100% of their stake in AFYA from September 2023 to December 2023. From July 2023 to March 2024, of the top 20 funds that own AFYA, 11 dumped 100% of their shares. A total of 7,195,250 shares, or 8% of the total number of shares outstanding, has been sold by the top 20 fund and institutional investors. The other more benign reason could be smart money wanting to lock in their huge capital gains from AFYA for 2023.

The latest guidance confirms the declining growth narrative. The projected growth in 2024’s net revenue and adjusted EBITDA equate to much lower growth than before. The lower end of the 2024 revenue projection implies a 9.6% growth, while the higher end of the revenue projection indicates a 13.08% growth. These are good figures for many companies but hardly for one that boasted an EBITDA and revenue CAGR of 48.67% and 44.53%, respectively.

That must have been the reason for analysts’ recent downward revision of AFYA’s revenue and earnings.

Do not get me wrong. Despite the downward revision, analysts did not downgrade the company (they kept their “STRONG BUY” rating) and they still expect AFYA to grow revenue and earnings in 2024 and 2025.

So why is AFYA’s growth story changing?

Risks From Regulatory Challenges

The cause is beyond AFYA’s hands. CEO Virgilio Gibbon explained in the earnings call regarding the regulatory change that has affected AFYA’s outlook,

So for the second question about the Mais Médicos 3 schedule. So we are expecting to deliver the proposal now by the current schedule by July of this year. And the answer will be only beginning of 2024 with the new change 2025. I’m sorry.

And by the new changing we have, the change was from the previous one. We got 36 opportunities to bid in order to participate on the public bid. And now with the change that each institution can only offer for one state that’s reduced to 36 from 36 to 23 campuses that will be allowed to bid for the Mais Médicos 3. So that’s all the updates on this front, okay.

What Still Do I Like About AFYA

The decline in growth rates is something I am concerned about, and if double-digit growth rates are all I care about, AFYA would no longer be part of my portfolio. However, to expect a company to continue its blistering growth rate of 40-50% indefinitely is just unrealistic.

What I care about is owning good businesses that are growing, can raise prices, have a moat, are supported by strong tailwinds, and have potential for future growth. I still see these in AFYA.

Growing Business

Management is confident that AFYA can continue to grow its revenue and earnings. Analysts agree too.

There are over 5 applicants for every medical school seat in Brazil, so the demand is certainly there, and strong demand comes the ability to raise prices.

AFYA is the largest medical education service in Brazil. In 2020, Brazil has roughly 35, 000 medical school seats spread over 345 medical schools. Afya has 3,203 approved medical seats, close to 10% of all the seats in Brazil.

This is set to grow as one of AFYA’s growth strategies is through acquisitions. Although the regulatory changes to limit the number of seats will pose a problem, it affects all the medical education providers equally. Being a dominant market player, I would argue that AFYA is best positioned to benefit from the change, as such challenges can provide more opportunities for it to acquire other seats at favorable prices.

Growing Tailwinds and Moat

AFYA’s moat comes from its unique business model that rides on the many needs that provide the tailwinds. In the words of AFYA’s CEO, he wants the company “to become reference on medical education in Brazil and create a lifelong learning experience that is extraordinary for our physicians, and we are serving every stage of the medical career, starting [with] the medical school, passing through the residence prep courses in all continuum and education programs that will fulfill these professional needs along their career“. In other words, AFYA aims to serve physicians from the time they are students until the point when they retire – and generate revenue throughout a physician’s professional career.

The Brazilian government continues to want to expand its physician population. The CEO explains,

So, what I believe is that the combination between the public policy that they’re aiming to expand more medical seats for countryside through the medical street, combined with any alternative way that can be from the legal side, if that is, will be the final solution, can be combined what the Minister of Education is expecting to have as a total expansion for the sector… I think it will be the largest impact around 9 to 10,000 seats in all of the cities that the Minister of Education is aiming to have additional program or additional seats as an increase of supply for the entire country.

This is not a hypothetical, “what-if” scenario. Brazil needs to grow not just the physician population to serve its people, but it needs to improve physician quality too.

The number of medical schools in Brazil has increased dramatically. In 2000, there was a boom in the opening of new medical schools. The problem lies in determining the quality of the physicians who graduate from these schools. Firstly, admission is based on the results of qualifying exams and each medical school decides on its qualifying examination. Secondly, although there is a standardized curriculum with the National Curricular Guidelines, the guidelines are not mandatory, and only about 85% of schools were compliant with this rule in 2014. Thirdly, there is a wide variety of assessment methods used across schools.

As an educator and curriculum designer myself, all these are red flags. How can a basic level of quality of the graduated medical practitioners be assured if the entry requirements, curriculum, and assessment are so varied?

Let’s assume that the different methods (admission, curriculum, and assessment) are equally good, a simple post-graduation assessment can make that determination if graduates from the different medical schools can pass a standardized test. However, according to the authors of this paper on the medical education science in Brazil,

Although there have been some attempts to administer national exams after the pre-clinical stage, the clinical stage, and upon graduation, unfortunately, none of these efforts were sustainable. Although national exams were also theoretically a part of the “More Physicians” law, until now, they were not enforced in practice.

The above leads to the next tailwind, which comes in the form of AFYA’s Continuing Education and Digital Services business. The authors on the medical education scene in Brazil continue,

In order to keep the physicians current in their knowledge and practice several institutions, such as universities, specialty medical societies, hospitals and centers of excellence provides courses, conferences, and lectures in each specialty. Often, those meetings and scientific production are converted into points. The responsibility to track those points acknowledging sufficiency in the performance of the physician continuing medical education is centered in each specialty medical societies and approved by the Scientific Council of the AMB. This system has the advantage to be unified, nevertheless, there is some criticism about the increasing costs for the physician personally to maintain those points.

Once physicians graduate, they need not apply for recertification, although that is encouraged. While recertification is voluntary, all doctors in Brazil are legally required to participate in CME (Continuing Medical Education) to maintain their license, following Federal Council of Medicine’s (CFM) Resolution No. 1.984/2012 which directly addresses the obligation of physicians in Brazil to participate in Continuing Medical Education programs.

AFYA’s Continuing Education fills this need for the growing physician population.

At the same time, AFYA’s Digital Services fills another need. To date, 265,000 users, representing more than 34% of all medical students and physicians in Brazil, are using AFYA’s Digital Services. As more people use it, the stickier it becomes and the stronger the moat, since physicians would find it convenient to communicate and share critical patient information through a common and secure digital platform like the one AFYA offers. In an environment where the quality of physicians is uncertain (due to the non-standard nature of the way medical schools admit, teach, and assess their students) being in an ecosystem where graduated physicians can continue to interact and learn from other physicians more experienced and knowledgeable than them can help everyone level up.

Growing Margins

CFO Luis Blanco said,

As a whole, we see in our three segments, margin expansions during 2024. Starting with the continued educational, what we see that we’re going to expand margins because we are having leverage, leveraging, operational leverage operations…

Regarding our digital service, what we see that with the expansions of our service, the expansions in our B2B users and the new B2B contracts, we are going to see increasing in margins year over year as well.

And in undergrad, we have the fact that we finalized the integrations of UNIT in last November. So it will be the first year that will be 100% of FITS having UNIMA/FITS FCM Jabotão being 100% integrated…

So with these scenarios, we are comfortable to give this guidance of 2024, whereas implied expansions in terms of EBITDA margins for 2024, if you compare to 2023.

And the margin expansion is across all three business segments. The CFO added,

… in terms of top line, we can expect around 10% in the undergrad segment, around 20% in the continuing educational, and around 30% in terms of digital service expansion in top line.

The 20% and 30% growth rates for Continuing Education and Digital Services sound great, but those are the smallest revenue-generating segments. The largest revenue contributor – Undergrad – is the slowest growing at 10%. In the short term, having the largest revenue segment growing the slowest is not a good thing, and investors are naturally concerned.

However, if we can project the growth for each segment a few years out, the narrative changes.

Assuming the growth rates of 10% for Undergrad, 20% for Continuing Education, and 30% for Digital Services remain constant for 2024, 2025, and 2026, the revenue contribution from the two smallest segments that made up a total of 13% of 2023’s revenue would contribute 20% in 2026, and if projected further out to 2028, those two segments could contribute up to 25% of AFYA’s total revenue.

Yes, the Undergrad segment would still be its largest revenue contributor, but an increasingly large portion of the revenue would be coming from the Continuing Education and Digital Services segments.

Previous, I wrote,

The Undergrad Segment provides educational services through undergraduate courses related to medicine, and other health sciences as well as other undergraduate programs.

The Continuing Education Segment provides specialization programs and graduate courses for certified physicians.

The Digital Services provides content and technology for medical education, clinical decisions software, practice management tools (that encompass electronic medical records, telemedicine and digital prescription for physicians), and doctor-patient relationship and provides access, demand, and efficiency for the healthcare players.

The current uncertainty from the regulatory challenges affects the Undergrad segment, but not the Continuing Education and Digital Services segment. I would add that there is less volatility in the earnings and revenue expected from these two smaller segments since they come from existing physicians and enrolled medical students, and so long as AFYA can provide programs, courses, and software solutions to value-add a growing population of doctors, these segment would continue to grow, through cross-selling and upselling AFYA’s plethora of services.

This speaks to the foresight the current management has, to expand its capabilities to generate additional revenue streams that are less likely to be disrupted by regulatory changes.

Growing Potential For Future Growth

The CEO talks up the B2B engagement,

This outcome underscores the vast opportunity in digital services, driven by the ramp-up in B2B engagements, securing new contracts with pharmaceutical industry companies, and the continuous expansion in B2B contracts…

Concurrently, we are expanding our ecosystem to facilitate new interactions and revenue streams beyond physicians, including engagements with pharmaceutical players, hospitals, labs, and drugstore chains. Evidence of this expansion is seen in the growth of our B2B strategy, fortifying our market presence and extending our reach. Consequently, we achieved a 64% year-over-year growth in our B2B revenues.

Currently, AFYA is keeping its B2B business to the Brazilian market, but this is a scalable solution, so once AFYA is ready to offer its Digital Services to the international market, it is easy to imagine the much larger total addressable market that AFYA’s B2B solution can serve.

Valuation

My valuation for AYFA ranges from $18.46 per share in my bear case scenario of just 5% growth in earnings, which is lower than the 5.8% price increase that AFYA can levy on their undergrads (according to Renata Couto during the earnings conference) and assuming a multiple compression to 10, to a high of $37.08 per share in my best-case scenario. In other words, even in my unlikely bear case, AFYA would be trading around its fair value at its closing price of $17.94 on 26 April 2024. If AFYA’s fair value is close to my estimate of $22.01, which was close to where it reached its 52-week-high, and close to consensus analysts’ price target of $23.52, buying AFYA at the current price offers at least a 37% margin of safety.

Even if I am wrong and AFYA is fairly valued now, paying fair value for a business that is still growing revenue and earnings, can raise prices, has a moat, is supported by strong tailwinds, and has potential for future explosive growth in the digital services segment, does not sound too bad. The risk and reward of investing in AFYA seem good to me.

By relative valuation, AFYA is also cheap at the current price. On a P/E, P/B, and EV/EBITDA basis, AFYA is trading below both its 5-year average as well as its peers.

Conclusion

AFYA has been battered due to a combination of factors. It is facing regulatory changes in Brazil. Its revenue and earnings growth rates are declining. And institutional investors have largely abandoned it.

However, as an investor looking to own a business that has a dominant position, continues to grow earnings and income, can raise prices, has a moat, is supported by strong tailwinds, and has the potential for future explosive growth in the digital services segment, AFYA is a potential candidate.

Plus, AFYA’s fastest growing segments, Continuing Education and Digital Services, can become major revenue contributors in time to come, which will provide even more predictability and stability in the company’s revenue and income growth.

After the massive price decline over the past 1 month, AFYA looks attractively valued again. With that wide margin of safety due to the depressed price, even a slight blended P/E expansion from 12.87 to 13.99 which is more in line with its slower growth rate could still offer investors a 31% capital gain in two years.

After the price ran up by 45% in the six months after my first article was published, I beat myself up for not increasing my position. Thanks to Mr Market, who has been very negative about AFYA lately, I managed to double my position. I believe Mr Market is mistaken about AFYA. Yes, growth has declined, but if AFYA can be viewed as a dependable and good business that can grow at around 10% a year, then it certainly deserves a higher multiple and is a BUY. If you are looking at AFYA as a business that is no longer in growth mode, and explosive growth is all that matters, then AFYA would be a SELL for you.

It is still a relatively small position in my portfolio, and as Brazil is a geographical location that I am not familiar with, I am assigning a BUY rather than a STRONG BUY.

Another reason for the BUY rather than a STRONG BUY lies in the decrease in its cash position, from $201 million in 2021 to $113.8 million in December 2023. For a company that seeks growth via acquisition as well as organically, having less cash may mean it has to borrow more and at higher interest rates. Having less cash will put a lid on its growth-via-acquisition strategy.

This is something I will keep in mind, but I would not be overly worried as the company is growing revenue and net operating cash flow nicely, and more importantly, the growth of the operating cash flow (43.11%) exceeds the growth of its total debt (35.87%), which tells me that this is a business that can grow organically and is not just dependent on spending to acquire more revenue. I am glad that management is being financially prudent and is making efforts to pay down debt rather than taking on more debt to go on an all-out acquisition frenzy. CFO Luis Blanco said,

The cash flow from operating activities was allocated to income tax and lease payments, CapEx activities, for the service of the financial debt, for our share buyback program, alongside the additional acquisitions of 15% of FMIT. Excluding the business combinations of UNIMA, we were able to generate R$391 million as free cash and reduce our net debt in the 12-month period… We continue to maintain a low cost of debt that remains below the CDI rates.

Please do your due diligence and decide your position sizing.